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 C O N T E N T S

Part 1 Return on Domestic and Foreign Securities 53

Risk of Combined Country Investments 54
The Investment Background 1 Global Investment Choices 58
Fixed-Income Investments 58
CHAPTER 1 International Bond Investing 60
The Investment Setting 3 Equity Instruments 60
May You Live in Interesting Times 3 Special Equity Instruments: Options 62
What Is an Investment? 4 Futures Contracts 63
Investment Defined 5 Investment Companies 63
Measures of Risk and Return 5 Real Estate 65
Measures of Historical Rates of Return 5 Low-Liquidity Investments 65
Computing Mean Historical Returns 7 Historical Risk-Returns on Alternative Investments 66
Calculating Expected Rates of Return 9 World Portfolio Performance 67
Measuring the Risk of Expected Returns 11
WEB APPENDIX 3A:
Risk Measures for Historical Returns 13
Determinants of Required Rates of Return 14 A Review of Bond Categories and Terminology (please go
The Real Risk-Free Rate (RRFR) 15 to the text’s website at www.reilly.nelson.com)
Factors Influencing the Nominal Risk-Free
Rate (NRFR) 15 CHAPTER 4
Risk Premium 17
Securities Markets and the Economy 71
Risk Premium and Portfolio Theory 18
Fundamental Risk versus Systematic Risk 19 What Is a Market? 72
Relationship between Risk and Return 19 Characteristics of a Good Market 72
Road Map for the Rest of the Book 20 Organization of the Securities Market 73
Primary Capital Markets 73
WEB APPENDIX 1A: Government of Canada Bond Issues 73
Provincial and Municipal Bond Issues 74
A Review of Statistics and the Security Market Line (please
Corporate Bond Issues 74
go to the text’s website at www.reilly.nelson.com) Corporate Stock Issues 74
Private Placements 75
CHAPTER 2 Secondary Financial Markets 76
The Asset Allocation Decision 25 Why Secondary Markets Are Important 76
Individual Investor Life Cycle 26 Secondary Bond Markets 76
The Preliminaries 26 Financial Futures 76
Life-Cycle New Worth and Investment Strategies 26 Secondary Equity Markets 77
Life-Cycle Investment Goals 28 Classification of Secondary Equity Markets 78
The Portfolio Management Process 29 Primary Listing Markets 78
The Need for a Policy Statement 30 Regional Stock Exchanges 83
Other Benefits 31 The Third Market 83
Input to the Policy Statement 32 Alternative Trading Systems (ATSs) 83
Investment Objectives 32 Detailed Analysis of Exchange Markets 84
Investment Constraints 36 Types of Orders 84
Some Common Mistakes 39 Exchange Market Makers 87
The Importance of Asset Allocation 40 Where Do We Go from Here? 88
Real Investment Returns after Taxes and Costs 41 Uses of Security-Market Indices 89
Returns and Risks of Different Asset Classes 42 Differentiating Factors in Constructing Market Indices 89
The Sample 89
CHAPTER 2 APPENDIX Weighting Sample Members 90
Objectives and Constraints of Institutional Investors 47 Computational Procedure 90
Stock-Market Indices 90
Price-Weighted Index 90
CHAPTER 3
Value-Weighted Index 92
Selecting Investments in a Global Market 51 Unweighted Index 93
The Case for Global Investments 52 Style Indices 94
Relative Size of Financial Markets 52 Global Equity Indices 95

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 CONTENTS vii

Bond-Market Indices 95 CHAPTER 7

Investment-Grade Bond Indices 96 Asset Pricing Models: CAPM and APT 161
High-Yield Bond Indices 96
Capital Market Theory: An Overview 161
Global Government Bond Indices 96
Background for Capital Market Theory 161
Composite Stock-Bond Indices 96
Developing the Capital Market Line 163
Comparison of Indices Over Time 96
Risk, Diversification, and the Market
Portfolio 167
Investing with the CML: An Example 170
Part 2 The Capital Asset Pricing Model 172
A Conceptual Development of the CAPM 172
Developments in Investment The Security Market Line 173
Theory 103 Relaxing the Assumptions 178
Differential Borrowing and Lending Rates 178
CHAPTER 5 Zero-Beta Model 178
Efficient Capital Markets 105 Transaction Costs 180
Why Should Capital Markets Be Efficient? 105 Heterogeneous Expectations and Planning
Alternative Efficient Market Hypotheses 106 Periods 180
Weak-Form Efficient Market Hypothesis 106 Taxes 181
Semistrong-Form Efficient Market Hypothesis 107 Beta in Practice 182
Strong-Form Efficient Market Hypothesis 107 Stability of Beta 182
Tests and Results of Efficient Market Hypotheses 107 Comparability of Published Estimates of Beta 182
Weak-Form Hypothesis:Tests and Results 107 Arbitrage Pricing Theory (APT) 183
Semistrong-Form Hypothesis:Tests From CAPM to APT 183
and Results 109 Using the APT 185
Strong-Form Hypothesis:Tests and Results 118 Multifactor Models in Practice 187
Behavioural Finance 121 Macroeconomic-Based Risk Factor Models 189
Explaining Biases 122 Microeconomic-Based Risk Factor Models 190
Fusion Investing 123 Extensions of Characteristic-Based Risk
Implications of Efficient Capital Markets 123 Factor Models 193
Efficient Markets and Technical Analysis 124
Efficient Markets and Fundamental Analysis 124
Efficient Markets and Portfolio Management 126 Part 3
CHAPTER 6 Analysis and Management of Common
An Introduction to Portfolio Management 131 Shares 199
Some Background Assumptions 131
Risk Aversion 131 CHAPTER 8
Definition of Risk 132 Economic and Industry Analysis 201
Markowitz Portfolio Theory 132 An Overview of the Valuation Process 202
Alternative Measures of Risk 133 Why a Three-Step Valuation Process? 202
Expected Return 133 General Economic Influences 202
Standard Deviation of Returns Industry Influences 204
for an Individual Investment 134 Company Analysis 205
Standard Deviation of Returns for a Does the Three-Step Process Work? 205
Portfolio 135 Economic Analysis 206
Standard Deviation of a Portfolio 141 Understanding Business Cycles 206
A Three-Asset Portfolio 149 Knowing Monetary Variables 208
Estimation Issues 150 Inflation and Interest Rates 210
The Efficient Frontier and Investor Utility 151 Forecasting Performance of the Stock
The Efficient Frontier 152 Market 213
Analysis of World Security Markets 215
CHAPTER 6 APPENDIX Industry Analysis 215
A. Proof that Minimum Portfolio Variance Occurs What Is an Industry? 215
with Equal Weights when Securities Have The Business Cycle and Industry Sectors 217
Equal Variance 157 Structural Economic Changes
B. Derivation of Weights that Will Give Zero Variance and Alternative Industries 221
when Correlation Equals –1.00 158 Evaluating the Industry Life Cycle 223
C. Indifference Curves and Investor Utility 159 Analysis of Industry Competition 225

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viii CONTENTS

CHAPTER 9 Advantages of Technical Analysis 275

Company Analysis and Stock Valuation 231 Challenges to Technical Analysis 276
Challenges to Technical Analysis
Company Analysis versus Stock Valuation 231
Assumptions 276
Growth Companies and Growth Stocks 232
Challenges to Technical Trading Rules 276
Defensive Companies and Stocks 232
Technical Trading Rules and Indicators 277
Cyclical Companies and Stocks 233
Contrary-Opinion Rules 278
Speculative Companies and Stocks 233
Follow the Smart Money 280
Value versus Growth Investing 233
Momentum Indicators 281
Economic, Industry, and Structural Links
Stock Price and Volume Techniques 282
to Company Analysis 233
Technical Analysis of Foreign Markets 289
Economic and Industry Influences 233
Technical Analysis of Foreign
Structural Influences 234
Exchange Rates 289
Company Analysis 234
Technical Analysis of Bond Markets 290
Firm Competitive Strategies 234
Focusing a Strategy 235
SWOT Analysis 236
Estimating Intrinsic Value 237
Present Value of Dividends 238 Part 4
Present Value of Free Cash Flow to Equity 242
Analysis and Management of Bonds 295
Present Value of Operating Free Cash Flow 243
Relative Valuation Ratio Techniques 247 CHAPTER 11
Estimating Company Earnings per Share 248
Bond Fundamentals 297
Company Sales Forecast 248
Estimating the Company Profit Margin 249 Basic Features of a Bond 297
Shoppers’ Competitive Strategies 249 Bond Characteristics 298
The Internal Performance 249 Rates of Return on Bonds 300
Importance of Quarterly Estimates 250 The Global Bond Market Structure 300
Estimating Company Earnings Multipliers 251 Bond Ratings 301
Macroanalysis of the Earnings Multiplier 251 Types of Bond Issues 302
Microanalysis of the Earnings Multiplier 251 Domestic Government Bonds 302
Making the Investment Decision 254 Government Agency Issues 305
Additional Measures of Relative Value 255 Municipal Bonds 306
Price/Book Value (P/BV) Ratio 255 Corporate Bonds 307
Price/Cash Flow (P/CF) Ratio 256 International Bonds 313
Price/Sales (P/S) Ratio 257 Obtaining Information on Bond Prices 314
Summary of Relative Valuation Ratios 257 Interpreting Bond Quotes 314
Analysis of Growth Companies 257
CHAPTER 12
Growth Company Defined 258
Actual Returns above Required Returns 258 The Analysis and Valuation of Bonds 319
Alternative Growth Models 258 Bond Valuation and Bond Yields 319
The Real World 262 The Present Value Model 319
Measures of Value Added 263 The Yield Model 320
Economic Value Added (EVA) 263 Computing Bond Yields 321
Market Value Added (MVA) 265 Calculating Future Bond Prices 326
Relationships between EVA and MVA 265 Realized (Horizon) Yield with Differential Reinvestment
The Franchise Factor 266 Rates 327
Site Visits and the Art of the Interview 266 Price and Yield Determination on Non-interest Dates 329
When to Sell 267 What Determines Interest Rates? 329
Influences on Analysts 268 Forecasting Interest Rates 330
Efficient Markets 268 Fundamental Determinants of Interest Rates 330
Paralysis of Analysis 268 The Term Structure of Interest Rates 334
Analyst Conflicts of Interest 269 Expectations Hypothesis 335
Global Company and Stock Analysis 269 Liquidity Preference (Term Premium) Hypothesis 338
Segmented Market Hypothesis 339
Trading Implications of the Term Structure and Yield
CHAPTER 10
Spreads 339
Technical Analysis 273 What Determines the Price Volatility for Bonds? 340
Underlying Assumptions of Technical Trading Strategies 340
Analysis 274 Duration Measures 341

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 CONTENTS ix

Modified Duration and Bond Price Volatility 344 Financial Futures 414
Bond Convexity 346 Interest Rate Futures 414
Stock Index Futures 415
CHAPTER 12 APPENDIX An Overview of Option Markets and Contracts 418
Duration and Convexity with Semi-annual Cash Flows 356 Option Market Conventions 418
Price Quotations for Exchange-Traded Options 419
The Fundamentals of Option Valuation 426
The Basic Binomial Approach 426
Part 5 The Binomial Approach Expanded 427
The Black-Scholes Valuation Model 430
Derivative Security Analysis 357 Properties of the Model 431
Estimating Volatility 433
CHAPTER 13
Valuing European-Style Put Options 436
An Introduction to Derivative Markets and Securities 359 Problems with Black-Scholes Valuation 437
Overview of Derivative Markets 360 Swaps 438
The Language and Structure of Forward Interest Rate Swaps 438
and Futures Markets 360 Extensions of Swaps 439
Interpreting Futures Price Quotations: An Example 362 Option-Like Securities 441
The Language and Structure of Option Markets 364 Warrants 441
Interpreting Option Price Quotations: An Example 365 Convertible Bonds 443
Investing with Derivative Securities 368 Callable Bonds 444
The Basic Nature of Derivative Investing 368
Basic Payoff and Profit Diagrams
for Forward Contracts 369
Basic Payoff and Profit Diagrams Part 6
for Call and Put Options 370
Option Profit Diagrams: An Example 374
Portfolio Management 451
The Relationship between Forward CHAPTER 15
and Option Contracts 377
Equity Portfolio Management Strategies 455
Put-Call-Spot Parity 377
Put-Call Parity: An Example 379 An Overview 455
Creating Synthetic Securities Using Put-Call Parity 380 Passive Equity Portfolio Management Strategies 457
Adjusting Put-Call-Spot Parity for Dividends 381 Index Portfolio Construction Techniques 458
Put-Call-Forward Parity 382 Tracking Error and Index Portfolio Construction 459
An Introduction to the Use of Derivatives Methods of Index Portfolio Investing 462
in Portfolio Management 384 Active Equity Portfolio Management Strategies 462
Restructuring Asset Portfolios Fundamental Strategies 463
with Forward Contracts 384 Technical Strategies 466
Protecting Portfolio Value with Put Options 386 Anomalies and Attributes 468
An Alternative Way to Pay for a Protective Put 388 Benchmarking and Computer Screening 470
Option Trading Strategies 390 Investment Styles 471
Protective Put Options 390 Value versus Growth Investing 471
Covered Call Options 390 Style Analysis 474
Straddles, Strips, and Straps 392 Asset Allocation Strategies 478
Strangles 394 Integrated Asset Allocation 479
Chooser Options 395 Strategic Asset Allocation 482
Spreads 396 Tactical Asset Allocation 482
Range Forwards 399 Insured Asset Allocation 484
Selecting an Asset Allocation Method 484
CHAPTER 14
CHAPTER 15 APPENDIX
Derivatives: Analysis and Valuation 407
Canadian Mutual Fund Project 488
An Overview of Forward and
Futures Trading 407
CHAPTER 16
Hedging with Forwards and Futures 410
Hedging and the Basis 410 Bond Portfolio Management Strategies 491
Understanding Basis Risk 411 Bond Portfolio Performance, Style, and Strategy 491
Valuation of Forward and Futures 412 Passive Management Strategies 494
The Cost to Carry Model 412 Buy-and-Hold Strategy 494
Contango and Backwardated 413 Indexing Strategy 495

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Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
x CONTENTS

Bond Indexing in Practice: An Example 496 Jensen Portfolio Performance Measure 574
Active Management Strategies 497 The Information Ratio Performance Measure 577
Interest Rate Anticipation 498 Comparing the Composite Performance Measures 578
Valuation Analysis 500 Application of Portfolio Performance Measures 580
Credit Analysis 500 Other Performance Measures 587
Yield Spread Analysis 504 Performance Attribution Analysis 587
Implementing an Active Bond Transaction 505 Measuring Market Timing Skills 590
Active Global Bond Investing 506 The Challenges of Benchmarking 591
Core-Plus Management Strategies 507 The Global Benchmark Problem 592
Matched-Funding Management Strategies 508 Implications of the Benchmark Problems 593
Dedicated Portfolios 508 Required Characteristics of Benchmarks 594
Immunization Strategies 510 Evaluation of Bond Portfolio Performance 594
Horizon Matching 516 Returns-Based Bond Performance Measurement 595
Contingent and Structured Management Strategies 518 Reporting Investment Performance 596
Contingent Immunization 518 Time-Weighted Returns 596
Dollar-Weighted Returns 597
CHAPTER 16 APPENDIX Performance Presentation Standards 598
Bond Immunization and Portfolio Rebalancing 528
WEB Part 7
CHAPTER 17
Professional Money Management, Alternative Valuation Principles and Practices 605
Assets, and Industry Ethics 531 WEB CHAPTER 19
The Asset Management Industry: Structure Analysis of Financial Statements (please go to the text’s
and Evolution 532
website at www.reilly.nelson.com)
Private Management and Advisory Firms 533
Investment Strategy at a Private Money
Management Firm 536 WEB CHAPTER 20
Organization and Management An Introduction to Security Valuation (please go to the
of Investment Companies 537 text’s website at www.reilly.nelson.com)
Valuing Investment Company Shares 537
Closed-End versus Open-End
Investment Companies 538 APPENDIX A
Fund Management Fees 540 CFA® Questions and Problems 607
Investment Company Portfolio Objectives 540
Breakdown by Fund Characteristics 541
Global Investment Companies 541
APPENDIX B
Mutual Fund Organization How to Become a CFA® Charterholder 647
and Strategy: An Example 541
Hedge Funds and Private Equity 546 APPENDIX C
Characteristics of a Hedge Fund 547
Code of Ethics and Standards of Professional
Hedge Fund Strategies 547
Risk Arbitrage Investing: A Closer Look 550 Conduct 649
Hedge Fund Performance 552
Private Equity 553 APPENDIX D
Ethics and Regulation in the Professional
Interest Tables 653
Asset Management Industry 559
Regulation in the Asset Management Industry 559
Standards for Ethical Behaviour 561 APPENDIX E
Examples of Ethical Conflicts 562 Standard Normal Probabilities 657
What Do You Want from a Professional Asset Manager? 563

CHAPTER 18 Comprehensive References List 659

Evaluation of Portfolio Performance 569
Glossary 677
Peer Group Comparisons 569
Risk-Adjusted Composite Performance Measures 570 Index 693
Treynor Portfolio Performance Measure 570
Sharpe Portfolio Performance Measure 573

NEL

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
 P R E F A C E

The pleasure of authoring a textbook comes from writing about a subject that you enjoy and
find exciting. As an author, you hope that you can pass on to the reader not only knowledge
but also the excitement that you feel for the subject. In addition, writing about investments
brings an added stimulant because the subject can affect the reader during his or her entire busi-
ness career and beyond.We hope what readers derive from this book will help them enjoy better
lives through managing their financial resources properly.
To accomplish this, you need to learn about the investment alternatives that are available
today and, what is more important, to develop a way of analyzing and thinking about invest-
ments that will remain with you in the years ahead when new and different investment
opportunities become available.
Because of its dual purpose, the book mixes description and theory. The descriptive mate-
rial discusses available investment instruments and considers the purpose and operation of
capital markets in Canada and around the world. The theoretical portion details how you
should evaluate current investments and future opportunities to develop a portfolio of invest-
ments that will satisfy your risk-return objectives.
Preparing this first Canadian edition has been challenging for two reasons. First, many
changes have occurred in the securities markets during the last few years in terms of theory,
new financial instruments, trading practices, and a significant credit/liquidity disruption.
Second, capital markets continue to become very global in nature. Consequently, early in the
book we present the compelling case for global investing. Subsequently, to ensure that you
are prepared to function in a global environment, almost every chapter discusses how invest-
ment practice or theory is influenced by the globalization of investments and capital markets.
This completely integrated treatment is to ensure that you develop a broad mindset on invest-
ments that will serve you well in the 21st century.

Intended Market
This text is addressed to both graduate and advanced undergraduate students who are looking
for an in-depth discussion of investments and portfolio management.The presentation of the
material is intended to be rigorous and empirical, without being overly quantitative.A proper
discussion of the modern developments in investments and portfolio theory must be rigorous.
The discussion of numerous empirical studies reflects the belief that it is essential for alterna-
tive investment theories to be exposed to the real world and be judged on the basis of how
well they help us understand and explain reality.

Key Features of the First Canadian Edition

When planning the Canadian edition of Investment Analysis and Portfolio Management, we
wanted to retain the original text’s traditional strengths and capitalize on new developments
in the investments area to make it the most comprehensive investments textbook available.
First is the unparalleled international coverage. Investing knows no borders, and although
the total integration of domestic and global investment opportunities may seem to contra-
dict the need for separate discussions of international issues, it in fact makes the need for
specific information on foreign markets, instruments, conventions, and techniques even
more compelling.

NEL xi

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
xii PREFACE

Second, today’s investing environment includes derivative securities not as exotic anom-
alies but as standard investment instruments. We felt that Investment Analysis and Portfolio
Management must reflect that reality. Consequently, our two chapters on derivatives are written
to provide the reader with an intuitive, clear discussion of the different instruments, their
markets, valuation, trading strategies, and general use as risk-management and return-
enhancement tools.
Third, Chapter 17, “Professional Money Management, Alternative Assets, and Industry
Ethics,” includes an extensive discussion of the hedge fund and private equity industries. In a
very short period of time, these forms of “alternative” assets have emerged as some of the
most important vehicles for attracting investment capital throughout the world.We provide a
discussion of how these industries are structured and how they have evolved over the past
decade, as well as a breakdown of the myriad portfolio strategies that hedge fund and private
equity managers employ.We also contrast the salient characteristics of these funds with more
traditional professional money management products, such as mutual funds.
Fourth, as well as many questions and problems in the end-of-chapter material, we have
included an appendix containing a significant number of CFA exercises, to provide more stu-
dent practice on executing computations concerned with more sophisticated investment
problems.
Fifth, throughout the book, we have included an analysis of Shoppers Drug Mart. Web
Chapters 19, “Analysis of Financial Statements,” and 20, “An Introduction to Security Valua-
tion,” provide a review of accounting and fundamental analysis along with an extensive
analysis of Shoppers. A review of these two Web chapters before studying Chapter 9 will be
beneficial for those students who have not had extensive exposure to financial statement
analysis.

Major Content Highlights

While retaining many of the key features of the U.S. text, the Canadian edition has thor-
oughly updated, reorganized, and streamlined the materials.

Chapter 2 In this asset allocation chapter, there is an extended discussion of the importance of the
policy statement and its components. We discuss several tax considerations and how they impact
the asset allocation decision, and provide an example of a risk tolerance questionnaire and exam-
ples of asset allocations across risk tolerances. We also demonstrate the importance of investing
early and regularly.We emphasize not only what should be done but also some common mistakes
by investors. Finally, we consider in detail how the asset allocation decision affects long-run risk-
return results, and how asset allocation differs among foreign countries and is changing.

Chapter 3 The review of current and historical returns supports the notion of global diversifica-
tion, and a new study of global assets supports the use of a global measure of systematic risk to
explain asset returns. We consider new investment instruments available for global investors,
including global index funds and, notably, exchange-traded funds (ETFs) for numerous countries
that trade continuously.

Chapter 4 Because of the significant growth in trading volume experienced by the electronic
communication networks (ECNs), this chapter reflects the new and rapidly evolving secondary
market for stocks. We also consider the rationale for the continuing consolidation of global
exchanges across asset classes of stocks, bonds, and derivatives. In addition, we note that the cor-
porate bond market also experienced major changes in how and when trades are reported and the

NEL

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
 PREFACE xiii

number of bond issues involved.We discuss growth and value style stock indices and analyze the
relationship among indices.

Chapter 5 This chapter considers various studies that both support the efficient market hypothesis
and provide new evidence of anomalies. We describe behavioural finance and discuss how it
explains many of the anomalies. There is a discussion of the practical implications of the recent
findings and how they relate to the efficient market hypothesis for analysts, portfolio managers,
and individual investors.

Chapter 6 This chapter builds the foundation for the theory of portfolio management.We develop
the Markowitz portfolio theory from mean and variance of a two-security portfolio all the way
to efficient frontier and optimal portfolio.

Chapter 7 This chapter presents the important transition between modern portfolio theory and
the capital asset pricing model (CAPM) in an intuitive way. The discussion also contains several
examples of how the CAPM and beta are measured and used in practice.We include a discussion
of the theory and practice using multifactor models of risk and expected return.We stress the con-
nection between the arbitrage pricing theory (APT) and empirical implementations of the APT,
both conceptually and with several examples.

Chapter 8 This chapter presents economic and industry analysis for investments.We consider both
the macroeconomic variables that affect capital markets and the industry factors that impact on
stock performance.We also discuss how to conduct an industry analysis.

Chapter 9 Following a unique discussion of a growth company and a growth stock, we provide a
valuation of Shoppers Drug Mart stock using the alternative techniques.We consistently empha-
size a key point that an outstanding company like Shoppers can have a fully valued or overvalued
stock. There is also a discussion dealing with the importance of quarterly earnings estimates. We
conclude the chapter with a consideration of several models that can be used to value true growth
companies.

Chapter 10 With the mixed views on the role of technical analysis in investment and portfolio
management, we introduce a number of measures and provide a discussion of the studies that have
tested the successes of the various rules. Some technical analysis rules are applied to Shoppers Drug
Mart to demonstrate how these rules may be interpreted.

Chapter 11 Because of the credit-liquidity problems encountered in the U.S. bond market during
2007 and 2008 that impacted security markets around the world, we have included several discus-
sions about the various bond types and their role in the credit-liquidity crisis.

Chapter 12 This chapter contains discussions on the various ways to calculate bond yields and their
respective meaning. Macaulay duration, modified duration, and bond price volatility are examined.
We also consider the concept of convexity, its calculation, and its determinants.

Chapter 13 We begin this chapter with traditional discussions of the “fundamentals” associated
with using derivative securities (e.g., interpreting price quotations, basic payoff diagrams, basic
strategies) and provide examples of both basic and intermediate risk management applications
using derivative positions. This includes the role that forward and futures contracts play in man-
aging exposures to equity, fixed-income, and foreign exchange risk.

NEL

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
xiv PREFACE

Chapter 14 We present a discussion linking valuation and applications of futures and options in
the context of investment management and offer examples designed to illustrate how investors use
futures and options in practice.We have also included a discussion of credit default swaps (CDSs)
and collateralized debt obligation (CDO); both received much attention during the recent global
financial crisis.

Chapter 15 This chapter contains a discussion of the relative merits of passive versus active man-
agement techniques for equity portfolio focusing on the important role of tracking error.We dis-
cuss equity investment style analysis in detail and explore asset allocation strategies.

Chapter 16 This chapter on bond portfolio management strategies includes an extended discus-
sion comparing active and passive fixed-income strategies, as well as examples of how the bond
immunization process functions. We have included material on how the investment style of a
fixed-income portfolio is defined and measured in practice.

Chapter 17 This chapter contains a discussion of the organization and participants in the profes-
sional asset management industry. Of particular note is an extensive update of the structure and
strategies employed by hedge funds as well as new analysis of how private equity funds function.
The chapter concludes with a discussion of ethics and regulation in the asset management industry.

Chapter 18 In this chapter, we provide an application of the performance measurement techniques

that are introduced throughout the chapter.The discussion includes a section on how the concept
of risk can be incorporated into the performance measurement process.We also cover evaluation
techniques beyond risk-adjusted measures, the challenges of benchmarking, bond portfolio eval-
uation, and how to report investment performance.

Web Chapter 19 Alongside the more traditional ratio analysis, this chapter also contains a detailed
comparison of alternative cash flow specifications and how they are used in valuation models and
credit analysis. We include a discussion of how to analyze operating leases and demonstrate how
the capitalization of these leases and the implied interest impacts the financial risk ratios for retail
firms like Shoppers Drug Mart. We also demonstrate how to measure operating leverage related
to business risk.

Web Chapter 20 We emphasize the two alternative approaches to valuation (present value of cash
flows and relative valuation).We discuss how and when they should be implemented and consider
the estimation of the variables that are relevant for all valuation models.

Supplement Package
The preparation of the first Canadian edition gave us the opportunity to create a supplement
product that provides more than just basic answers and solutions.We are indebted to the sup-
plement writers who devoted their time, energy, and creativity to making this the best
supplement package.

Instructor’s Resource CD-ROM (0-17-647836-1) Instructors can get quick access to all of these
ancillaries from the easy-to-use Instructor’s Resource CD-ROM (IRCD), which lets the user
electronically review, edit, and copy what’s needed.The CD contains an Instructor’s Manual, a Solu-
tions Manual, a Test Bank in Microsoft® Word and in ExamView®, and PowerPoint® slides.

NEL

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• Instructor’s Manual. The Instructor’s Manual, written by the text authors, contains a brief out-
line of each chapter’s key concepts and equations that can be easily copied and distributed to
students as a reference tool.
CFA • Solutions Manual. This contains all the answers to the end-of-chapter questions and solutions
to end-of-chapter problems. It also includes all of the solutions for the CFA questions and
problems found in Appendix A.The text authors and technical checker, Ann Miciak, were ever
diligent in the preparation of these materials, ensuring the most error-free solutions possible.
• Test Bank. The Test Bank includes an extensive set of questions and problems and complete
solutions to the testing material.
• Computerized Test Bank. The ExamView® computerized testing program contains all of the
questions in the Test Bank. ExamView® is an easy-to-use test-creation software compatible
with Microsoft® Windows® operating systems or Macintosh® computers. Instructors can
add or edit questions, instructions, and answers, and select questions by previewing them on
the screen, selecting them randomly, or selecting them by number. Instructors can also create
and administer quizzes online, whether over the Internet, a local-area network (LAN), or a
wide-area network (WAN).
• PowerPoint® Slides. A comprehensive set of PowerPoint® slides is available on the IRCD.
Each chapter has a self-contained presentation that covers all the key concepts, equations, and
examples within the chapter.The files can be used as is for an innovative, interactive class
presentation. Instructors who have access to Microsoft® PowerPoint® can modify the slides
in any way they wish, adding or deleting materials to match their needs.

Rotman Portfolio Manager (RPM) is one of the most robust Portfolio Simulations avail-
able. The software has been designed to simulate the look, feel, and functionality of propri-
etary applications that are used in leading financial institutions. The application allows
students to manage a fantasy portfolio of stocks, bonds, futures, and options using real market
data. RPM offers students advanced trading and portfolio management features that give
them the ability to focus their time on the portfolio design and management process, rather
than tedious trade execution and portfolio trading. Professors can register and have their stu-
dents trading within minutes! Nelson Education can provide access to Rotman Portfolio
Manager at substantial savings to students.
Product Support Web Site Investment Analysis and Portfolio Management’s web site at
www.reilly.nelson.com includes a variety of up-to-date teaching and learning aids for both
instructors and students. Students can also go directly to the text web site to link to the Internet
addresses in the text margins.

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 A C K N O W L E D G M E N T S

So many people have helped us in so many ways that we hesitate to list them, fearing that we
may miss someone.Accepting this risk, we will begin with the University of Calgary because
of their direct support.We are also grateful to the following who participated in the reviewing
of the first Canadian edition and its original proposal:
Ata Assaf, University of Windsor
David Grusko, Red River College
Larbi Hammami, McGill University
Sergey Isaenko, Concordia University
W. M. Lawson, Carleton University
Mary M. Oxner, St. Francis Xavier University
Wulin Suo, Queen’s University
Francis Tapon, University of Guelph
Jun Yang, Acadia University
We truly appreciate the dedication of the many people responsible for the development
and production of Investment Analysis and Portfolio Management. Special thanks to the
always supportive and professional staff at Nelson Education Ltd.: Elke Price, Senior
Developmental Editor; Craig Dyer, Senior Acquisitions Editor; Anne Nellis, Senior
Content Production Manager; Dave Ward, Executive Marketing Manager; Ferial Suleman,
Production Coordinator; and Valarmathy Munuswamy, Project Manager; and thanks also
to our Copy Editor, Michael Kelly; our proofreader, Integra; and our Technical Checker,
Ann Miciak. And finally, special thanks to Francis Tapon at the University of Guelph for
providing the Alternative Viewpoint features.
We are convinced that professors who want to write a book that is academically
respectable and relevant, as well as realistic, require help from the “real world.”We have been
fortunate to develop relationships with a number of individuals (including a growing number
of former students) whom we consider our contacts with reality.
Peggy Hedges would like to thank her colleagues, former clients, and former students. I
appreciate their desire to have information presented in a meaningful and straightforward
fashion. In particular, thank you to Larry A. Wood, who continues to be an inspiration,
mentor, and business partner.As well, I would have been lost in data without the skilled assis-
tance of Katrina Montgomery, resource librarian at the Haskayne School of Business.
Philip Chang would like to thank his colleagues at Haskayne School of Business for sup-
porting his development of the investments and portfolio management courses over the years.
The tradition of teaching excellence at Haskayne continues to challenge us to be better
teachers.
We would like to thank all of our former students, too; their curious eyes and critical
minds are always an inspiration. Special thanks go to the following individuals for their assis-
tance with analysis of data and creation of graphics: Dan Zuniga, Karen Chang, Sarah Mody,
Dawei Zhang, and Tony Zaremba, CFA.

Peggy L. Hedges
Philip C. Chang
Calgary,AB

xvi NEL

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 A B O U T T H E A U T H O R S

Frank K. Reilly is the Bernard J. Hank Professor of Finance and former dean of the Men-
doza College of Business at the University of Notre Dame. Holding degrees from the Uni-
versity of Notre Dame (B.B.A.), Northwestern University (M.B.A.), and the University of
Chicago (Ph.D.), Professor Reilly has taught at the University of Illinois, the University of
Kansas, and the University of Wyoming in addition to the University of Notre Dame. He has
several years of experience as a senior securities analyst, as well as experience in stock and bond
trading.A Chartered Financial Analyst (CFA), he has been a member of the Council of Exam-
iners, the Council on Education and Research, the grading committee, and was Chairman of
the Board of Trustees of the Institute of Charted Financial Analysts and Chairman of the Board
of the Association of Investment Management and Research (AIMR) (now the CFA Institute).
Professor Reilly was named on the list of Outstanding Educators in America and has received
the University of Illinois Alumni Association Graduate Teaching Award, the Outstanding
Educator Award from the M.B.A. class at the University of Illinois, and the Outstanding
Teacher Award from the M.B.A. class and the Senior Class at Notre Dame. He also received
from the CFA Institute both the C. Stewart Sheppard Award for his contribution to the
educational mission of the Association and the Daniel J. Forrestal III Leadership Award for
Professional Ethics and Standards of Investment Practice.

Keith C. Brown holds the position of University Distinguished Teaching Professor of

Finance and Fayez Sarofim Fellow at the McCombs School of Business, University of Texas.
He received his B.A. in Economics from San Diego State University. He received his M.S.
and Ph.D. in Financial Economics from the Krannert Graduate School of Management at
Purdue University. He has specialized in teaching Investment Management, Portfolio
Management and Security Analysis, Capital Markets, and Derivatives courses at the under-
graduate, M.B.A., and Ph.D. levels and has received numerous awards for teaching innovation
and excellence, including election to the University’s prestigious Academy of Distinguished
Teachers. In addition to his academic responsibilities, he has also served as President and Chief
Executive Officer of The MBA Investment Fund, L.L.C., a privately funded investment
company managed by graduate students at the University of Texas.
Professor Brown has published more than 40 articles, monographs, chapters, and papers
on topics ranging from asset pricing and investment strategy to financial risk management.
In August 1988, Professor Brown received his charter from the Institute of Chartered
Financial Analysts (ICFA). He has served as a member of AIMR’s CFA Candidate Curriculum
Committee and Education Committee, and on the CFA Examination Grading staff.
Professor Brown is the co-founder and senior partner of Fulcrum Financial Group, a port-
folio management and investment advisory firm located in Austin, Texas, and Las Vegas,
Nevada, that currently oversees portfolios holding a total of $60 million in fixed-income
securities. He is an Advisor to the Boards of the Texas Teachers Retirement System and the
University of Texas Investment Management Company and serves on the Investment
Committee of LBJ Asset Management Partners.
He has lectured extensively throughout the world on investment and risk management
topics in the executive development programs for such companies as Fidelity Investments, JP
Morgan Chase, BMO Nesbitt Burns, Merrill Lynch, Chase Manhattan Bank, Chemical Bank,
Lehman Brothers, Union Bank of Switzerland, Shearson, Chase Bank of Texas, The Beacon
Group, Motorola, and Halliburton.

NEL xvii

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xviii ABOUT THE AUTHOR

Peggy L. Hedges is a Senior Instructor at the Haskayne School of Business at the Univer-
sity of Calgary. Her background includes education and experience in financial services.
Before joining the Haskayne School of Business in 1990, Peggy worked for the Canadian
Imperial Bank of Commerce (CIBC) as both an administration and commercial lending
manager.
Peggy received a B.Sc. and M.B.A. from the University of Calgary. She has a Ph.D. in
Environmental Planning from the University of Strathclyde and is a Fellow of the Institute
of Canadian Bankers (FICB) and a Fellow of the Canadian Securities Institute (FCSI).
Peggy has published articles on topics ranging from small business financing, alternative
funding for defined-benefit pension plans, and risk analysis of catastrophic bonds. She has
co-authored another textbook with William Lasher and Terry Fegarty entitled Practical
Financial Management; this textbook is in its second Canadian edition.
Peggy has developed and taught undergraduate and graduate courses in corporate, per-
sonal, investment, institutional, and public finance for the University of Calgary, University of
Northern British Columbia, Athabasca University, and Mount Royal College. She has
received the Dean’s Award for Teaching Excellence and has been nominated several times for
teaching awards. As well, she is a co-owner of a company that specializes in financial educa-
tion to executives.

Philip C. Chang is an Associate Professor of Finance at the Haskayne School of Business at

the University of Calgary. He has formerly served as Chair of Finance and Operations Man-
agement and Associate Dean (International) at Haskayne.
Philip received his Ph.D. in Economics from University of Illinois at Urbana-Champaign
and his M.A. and B.A. in Economics from National Taiwan University. He has taught in the
fields of economics, statistics, investments, and corporate finance at the business schools of
University of Illinois, University of Calgary, National Chengchi University in Taipei, and
Peking University in Beijing. He has received many teaching excellence awards over the
years. Philip’s publications range from mergers, risk management, cost of capital, and bank
fund reallocation, to the linkage between finance and corporate social responsibility.

We are responsible for the complete revision and Canadianization of this text, so we invite
you to send your comments, suggestions, or questions about the book directly to us.

Peggy L. Hedges Philip C. Chang

University of Calgary University of Calgary
[email protected] [email protected]

xviii NEL

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 P A R T

The Investment Background

CHAPTER 1
The Investment Setting

CHAPTER 2
The Asset Allocation Decision

CHAPTER 3
Selecting Investments in a Global Market

CHAPTER 4
Securities Markets and the Economy

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The chapters in this section will to calculate an investment’s investment instruments found in
provide a background for your return, and what factors deter- global markets.We conclude the
study of investments by answering mine an investor’s required return chapter with a review of the his-
the following questions: on a particular investment.The torical rates of return and mea-
latter point will be important in sures of risk for a number of
• Why do people invest?
subsequent analyses when we different asset groups.
• How do you measure the
work to understand investor In Chapter 4, we examine
returns and risks for various
behaviour, the securities market- how markets work in general,
investments?
place, and the valuation of various and then specifically focus on
• What factors should you
investments. the purpose and function of pri-
consider when you make asset
Because the ultimate decision mary and secondary bond and
allocation decisions?
facing an investor is the makeup stock markets. Significant
• What investments are
of his or her portfolio, Chapter 2 changes have occurred in the
available?
deals with the all-important asset operation of the securities mar-
• How do securities markets
allocation decision.This includes kets, and after discussing these
function?
specific steps in the portfolio changes and the rapid develop-
• How and why are securities
management process and factors ment of new capital markets
markets in the world
that influence the makeup of an around the world, we speculate
changing?
investor’s portfolio over his or her about how global markets will
• What are the major uses of
life cycle. continue to consolidate and
security-market indices?
To minimize risk, investment increase available investment
• How can you evaluate the
theory asserts the need to diver- alternatives.We finish the
market behaviour of common
sify. Chapter 3 begins our explo- chapter by examining and com-
stocks and bonds?
ration of investments available to paring a number of stock-market
• What factors cause differences
investors by making an overpow- and bond-market indices available
among stock- and bond-
ering case for investing globally for the domestic and global
market indices?
rather than limiting choices to markets.
We begin by considering why only Canadian securities. Building
an individual would invest, how on this premise, we discuss several

2 PART 1 The Investment Background NEL

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C H A P T E R
1 The Investment Setting

After you read this chapter, you This initial chapter discusses several topics basic to the subsequent
should be able to answer the fol- chapters, beginning with the definition of the term investment and
lowing questions: discussing the returns and risks related to investments.This leads to a
1. Why do individuals invest? presentation of how to measure the expected and historical returns for
an individual asset or a portfolio of assets. In addition, we consider
2. What is an investment?
how to measure risk for an individual investment and for an invest-
3. How do investors measure the ment that is part of a portfolio.
return on an investment? Next we discuss the factors that contribute to an asset’s total risk
4. How do investors measure risk? and that impact the return demanded. Because most investors hold
portfolios, it is necessary to consider an asset’s risk when it is a part of
5. What factors contribute to the
a large portfolio.
return that investors require on
The final section provides an overview of how macroeconomic
various investments?
and microeconomic events can affect an asset’s required rate of return
6. What macroeconomic and over time.
microeconomic factors con-
tribute to changes in the 1.1 May You Live in Interesting Times
required return for investments?
Whether a curse or a blessing, we certainly are now living in inter-
esting times. At the time of writing this text, the news of the day
talked about the new global financial crisis, there were bailouts offered
to some industries and asked for by others. We knew the markets
were in a downturn—was this downturn to be a recession or would
it free-fall into a depression? There was speculation by analysts and
commentators daily on whether we had hit bottom, were we to
expect further declines, or were we on a recovery. Many questioned
why governments and analysts didn’t see this coming, or if they
did why they didn’t do anything sooner. Surely we have learned from
the downturns in the markets before. By the time this text is in print,
you hopefully will be in a position to answer some of these questions.
Over time, there have certainly been a number of interesting
examples of incredibly high prices and speculative booms that have, in
some cases, been fuelled by easy credit terms. For example, there was
the tulip-bulb craze of the mid-1600s, the South Sea bubble in the
early 1700s, the market crash of 1929, Black Monday in 1987, and
even the Internet bubble of 2000.1 Even though we have seen

1 See Burton Malkiel’s A Random Walk Down Wall Street (2007,W.W. Norton & Company
Inc., New York) for a very detailed and interesting discussion of historical bubbles and busts.

NEL

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4 PART 1 The Investment Background

numerous examples, no one has a good method for predicting whether we are in a specula-
tive boom or when and if the bubble will collapse. Haven’t we learned from our mistakes?
That leaves us to agree with Mark Twain when he noted that investing is fraught with
uncertainty: “October.This is one of the peculiarly dangerous months to speculate in stocks
in. The others are July, January, September, April, November, May, March, June, December,
August and February.”
There are a number of There are numerous reasons and explanations for what has happened and how even when
interesting websites that a number of investors are losing money, many other investors continue to invest and make
discuss investing manias. money. So this leaves us to question whether, in these interesting times, there are still good
Check out one recent
article at
opportunities to invest? If so, where and how can we identify such investments? That is the
http://www.forbes. purpose of this textbook: to learn about what makes a good investment, how to construct a
com/2008/10/21/ portfolio, and how to evaluate the results.
bubble-tulipmania-crash-
pf-ym-in_avb_1020
youngmoney_inl.html.
1.2 What Is an Investment?
For most of your life, you will be earning and spending money. Rarely, though, will your
current income exactly balance with your consumption desires. When current income
exceeds current consumption desires, people tend to save the excess.They can do any of sev-
eral things, including giving up the immediate possession of these savings for a future larger
amount of money that will be available for future consumption. This trade-off of present
consumption for a higher level of future consumption is the reason for saving.What you do
with the savings to make them increase over time is investment.2 Conversely, those who
consume more than their current income (i.e., borrow) must be willing to repay more than
they borrowed.
The rate of exchange between future consumption (future dollars) and current consumption
(current dollars) is the pure rate of interest. People’s willingness to pay this difference for bor-
rowed funds as well as their desire to receive a surplus on their savings give rise to an interest
rate referred to as the pure time value of money. This interest rate is established in the capital
market by a comparison of the supply of excess income available (savings) to be invested and
the demand for excess consumption (borrowing) at a given time.An exchange of $100 of cer-
tain income today for $104 of certain income one year from today means that the pure rate
of return on a risk-free investment (i.e., the time value of money) is 4% (104/100 ⫺ 1).
The investor who gives up $100 today in order to consume $104 of goods and services
in the future assumes that the general price level in the economy stays the same. Such price
stability is rare as we have seen inflation rates vary from almost 0% in 1994 to over 12% in
1981, with an average of about 4.7% per year between 1970 and 2008. If investors expect a
change in prices, they will require higher returns to compensate for it. For example, if our
investor expects 2% inflation over the investment period, he or she will require $106 in the
future to defer the $100 of consumption during an inflationary period (a 6% nominal, risk-
free rate will be required instead of 4%).
Further, if the future payment from the investment is not certain, the investor will
demand a rate higher than the nominal risk-free rate.The uncertainty of the payments from
an investment is the investment risk.The additional return added to the nominal, risk-free
rate is called a risk premium. Thus, in our example, the investor demanded $110 one year
from now to compensate for the uncertainty; the extra $4 (4%) would be considered a risk
premium.

2 In contrast, when current income is less than current consumption desires, people borrow to make up the difference.
Although we will discuss borrowing on several occasions, the major emphasis of this text is how to invest savings.

NEL

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 CHAPTER 1 The Investment Setting 5

1.2.1 Investment Defined

Investment is the current commitment of dollars for a period of time in order to derive
future payments that compensate the investor for (1) the time the funds are committed,
(2) the expected rate of inflation, and (3) the uncertainty of the future payments. Similarly,
this definition includes all types of investments, including investments by corporations in plant
and equipment and investments by individuals in stocks or shares,3 bonds, commodities, or
real estate. In all cases, the investor is trading a known dollar amount today for some expected
future stream of payments that will be greater than the current outlay.
At this point, we have answered the questions about why people invest and what they
want from their investments. How investors select investments that will give them their
required rates of return is a central question of this book.

1.3 Measures of Risk and Return

In order to choose among various investments, you need to estimate and evaluate the
expected risk-return trade-offs.Therefore, you must understand how to properly measure the
investment’s return and the risk.To meet this need, we examine how to measure both histor-
ical and expected rates of return and risk. Given the historical returns, we will then review the
traditional measures of risk for a historical time series of returns (i.e., variance and standard
deviation).
Lastly, we must estimate an investment’s expected rate of return. Obviously, such an esti-
mate contains a great deal of uncertainty, and we present measures of this uncertainty or risk.

1.3.1 Measures of Historical Rates of Return

Often you need to compare alternative investments with widely different prices or lives. For
example, you might want to compare a stock currently selling for $10 that pays no dividends
with a stock selling for $150 that pays an annual dividend of $5. To properly evaluate these
two, their historical returns must be compared.
When we talk about an investment’s return we are concerned with the change in
wealth resulting from this investment. This change can either be due to cash inflows,
such as interest or dividends, or be caused by a change in the price of the asset (positive
or negative).
Suppose a $200 investment at the beginning of the year is worth $220 at the end of the
year:What is your return for the period? The period over which you own the investment is
called its holding period, and the return over that period is the holding period return
(HPR). In this example, the HPR is 1.10, calculated as follows:

Ending Value of Investment

1.1 HPR ⴝ
Beginning Value of Investment
$220
ⴝ ⴝ 1.10
$200

This value will be greater than one (1.0) if you received a positive return during the period.
A value less than one means that wealth declined or you experienced a negative return. A
zero HPR indicates that you lost all your money.

3 We will use the term stock and shares interchangeably.

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